It is always
painful to start the year off on a sour note. We traditionally look forward to
the New Year as it seems so full of hope and promise and change for the better.
The pundits and analysts have been comfortably kicking back in the driver's
seat with correct predictions in the rearview mirror, friendly faces in the sideview mirrors, modest gains shining from the skies
above, and timid inflation cowering in the crosswalk in the path of the
prognosticators' Ferraris and Escalades. So what a rude awakening we have
received with these first two trading days of the year, especially since both
days started out with positive news on drops in oil combined with nice positive
openings on the markets. I will go into some of the specifics of the carnage at
the end. But I will point you to a good set of charts
from my man Mike. His work reminded me that I would be pre-mature in
calling a top in the market here (although I sure am tempted to do so anyway!).
However, if we get more indices falling back under their 50DMAs (still a ways
away for most), I will feel pretty confident in calling the highs on January 3,
2005 the highs for the year.

So what was
today's excuse for the selling? It turns out that the market trembled at some ominous
words from the Fed's minutes of its December 14, 2004 meeting. The Fed appears
to fret about inflation and higher interest rates…and when the Fed frets, the
market tends to have a conniption. First, note that the market was looking bad
yesterday, and the selling has already begun before the minutes were released.
If you are one of those people who needs to find a
reason for the market's decline, you could certainly fall back on the old line
that the market looks forward, and it must have seen the Fed's hammer coming. I
would respond with my characteristic skepticism and say instead that the market
was already in sell mode and was looking for excuses to make its point. And what
an excuse the Fed gave us! I will try my own bullet point summary and offer up
my own opinion of whether we should care at all about this stuff.

I start with
the one quote that probably sent the most fear through the collective heart of
the market:

Some members of the Fed have decided to
wake up and FINALLY acknowledge that our financial markets and housing markets
are fraught with speculative frenzy thanks to the Fed's easy money policies:"Some participants believed that the prolonged
period of policy accommodation had generated a significant degree of liquidity
that might be contributing to signs of potentially excessive risk-taking in
financial markets evidenced by quite narrow credit spreads, a pickup in initial
public offerings, an upturn in mergers and acquisition activity, and anecdotal
reports that speculative demands were becoming apparent in the markets for
single-family homes and condominiums."

Here are the
remaining main points I want to highlight from these minutes:

1.The economy appears strong: "The information received at this meeting
suggested that the economy expanded at a moderate pace over the third quarter
and into the current quarter. Consumer spending was solid, and investment
spending remained strong. Manufacturing production increased at a modest pace,
and employment gains in October and November indicated that the labor market
continued to improve gradually."

2.Inflation is relatively tame: "Core inflation measures remained subdued,
albeit running at a slightly higher pace than last year, owing, in part, to the
indirect effects of higher energy prices." Also - "With some economic
slack persisting and longer-term inflation expectations well-anchored,
inflation was anticipated to remain subdued."

3.Even the more hawkish members of the Fed agreed that
the outlook for inflation appears stable. But they insist on tingeing these
expectations with warnings: "A
number of participants cited the recent depreciation of the dollar on foreign
exchange markets, elevated energy costs, and the possibility of a slowing in
underlying productivity growth as factors tending to boost the upside risks to
their inflation outlook, though, on net, they saw the risks to stable
underlying inflation as still balanced." Also - "A number of
participants cited developments that could pose upside inflation risks…The increase over the last few months in five-year
measures of inflation compensation derived from Treasury nominal and
inflation-indexed securities might be a warning sign that expectations were not
as well anchored as they had been over the summer." And finally - "Despite
these concerns, participants generally expected that inflation would remain low
in the foreseeable future."

4.Job growth is OK - not great but also not bad - and
should continue to support healthy levels of consumer spending: "…when viewed over several months, labor market
conditions were generally seen as gradually improving. That improvement was
expected to persist and, along with higher wealth and relatively low interest
rates, would support further gains in spending by households."

5.Consumers should continue to feel richer and spend
accordingly: "…increasing equity and home prices had boosted
household net worth, leaving consumers well positioned to maintain a brisk pace
of spending."

6.The global economy appears to be sluggish: "Economic activity in most of the major foreign
industrial countries slowed in the third quarter, and data for the fourth
quarter pointed to continued subpar growth."

7.The market increased its inflation expectations after
the November Fed meeting: "…higher-than-expected
inflation data, remarks by the Chairman that were viewed as pointing to future
rate increases, and the depreciation of the dollar all led market participants
to price in a somewhat steeper path for future policy."

8.Productivity may be slowing and companies may need to
raise prices to make up for the resulting increase in costs: "Most participants acknowledged some
significant uncertainties in their outlook, including the effects of the
expiration of the partial-expensing provision for investment at the end of 2004
and recent indications of a softening in high-tech spending in the United
States and elsewhere. The possible downshift in the pace of high-tech spending
also raised the possibility of an erosion of profit margins that could result
from a slackening in the pace of technology-led productivity growth and the
associated increase in cost pressures."

9.The Fed is somewhat pessimistic about our ability to
exercise some fiscal discipline and weaker global economies may exacerbate
current imbalances: "Some
participants believed that the odds of significant deficit reduction over the
next few years were remote while others were more optimistic. Regarding global
imbalances and the current account deficit in the United States, a number of
participants expressed doubts that such imbalances would be reduced in the
near-term. Better global balance would require not only greater national saving
in the United States
but also a notable strengthening in domestic demand among major trading
partners. Such a strengthening seemed unlikely in the near term given the
recent softening in the economies of several important industrial countries."

10.The Fed may be getting irritated at its
inability to push up longer-term interest rates: "participants noted that investors anticipated
further increases in the federal funds rate over the coming year, but
intermediate- and long-term interest rates along with financial conditions more
generally had remained quite supportive of growth. A few participants commented
that [this] might signal that expectations of longer-term growth had been
marked down."

Overall, it is
easy to see why the market panicked. For someone looking for an excuse to lock
in 2003's profits, these minutes give you plenty of negativity to hang your hat
on. We can also see why tech suffered particularly devastating blows: the Fed
specifically noted signs of weakness in tech spending. On the surface, the Fed
is definitely trying to appear less market-friendly. This is quite a jolt and
could signal a true change in tone and approach by the Fed. If indeed enough
Fed participants are finally willing to express their concerns about the
speculative fervor in various markets, you can bet that it is only a matter of
time before the Fed looks to methods for reining in these excesses. For
example, those of you speculating in the housing markets should take very close
and careful notes.

But what I
find most interesting is that these minutes take pains not to sound alarmist
about inflation. The headlines in the media rang loud about how the Fed is
suddenly afraid of inflation and that the outlook for inflation had suddenly
accelerated. A more careful reading demonstrates that this is far from true.
The Fed is still in double-speak mode on inflation. On balance, they are not
worried and all looks well and stable. But they are throwing a few bones out
there for the inflation hawks to remind the market that they remain serious and
committed to their primary role as keepers of stable prices. If you want to
sell everything you won because of these Fed minutes, do not do it because of
fears of inflation!

In a similar
vein, you can see how the Fed remains quite cautious on the health of the
American and global economy. Again, they are trying not to sound alarmist, but
the remarks about weak industrial partners belie any concerns the Fed may have
about inflation. It is hard to imagine inflation roaring out of control when
global demand is slackening. The Fed is also a bit conflicted in its growing
realization that it cannot let speculative excesses continue much longer.
Remember - they continue to expect strong housing prices and a robust equity
market to provide fuel for healthy consumer spending.

Finally, for
all you Fed haters out there (I am trying to be a reformed hater), these minutes clearly demonstrate that the Fed is on the
case. Sure they are not yet speaking in one voice about the bad things that ail
us, the minority of realists are getting more vocal.
And while they may have left the spigot of easy money flowing far too long,
they are quite aware of the dire implications of allowing speculative excess to
continue too long. I practically fell out my chair to see them raising an
eyebrow or three at the recent rise in IPOs! The main question now is whether
the Fed is already too late in calming down speculation. Only time will tell,
but don't bet against the Fed on this one. There is mucho pain ahead for all
you speculators out there!

So, as we
survey the landscape, we see nothing but carnage. Just about everything that
moves got pummeled. I think the dollar and interest rates were about the only
financial instruments that went up. Even Google (GOOG) could not pull off
another one of its counter-NASDAQ tricks and go up in the face of pain
everywhere else in techland. Gold also got another head slap and now trades a
hair below the 200DMA…a further move below that level would be a major sell
signal. While I am still convinced of the longer-term soundness of gold as a
bet against the dollar and America's
ability to rein in deficit-spending, I cannot ignore the message from the
market. A further breakdown in gold will signal a major pause in the bullish
story, and we will need to take a fresh look at gold's prospects.

As I stated at
the beginning of this missive, I am VERY inclined to call a top in all the
major indices now. However, this call could very well be pre-mature. There are
no confirming signals for this dire prediction, just warning signs. The Fed has
been removing the pressure from the pedal, and while they have put on the
gloves for choking the market, they have yet to tighten their grip. And if this
is a top, you can bet the market is not going to give it up easily. The next
stop is earnings later this month. If companies can at least manage to avoid
saying naughty and nasty things, the bulls may get inspired one last time to
make a run for the hills. We could even see marginal new highs. After that, I
strongly suspect the tank will be running on fumes. But for you speculators,
the jig may have already ended.